Budget Cuts Haven't Narrowed Defense Moats

Matt Coffina: For Morningstar StockInvestor, I'm Matt Coffina. I'm joined today by Neal Dihora, who is an equity analyst covering the defense sector. We're going to talk about the prospects for defense and his top idea in the industry.

Neal, thanks for joining me.

Neal Dihora: Thanks for having me.

Coffina: So, the defense industry tends to have a lot of wide-moat companies. Can you tell me the main sources of economic moats for defense?

Dihora: Yeah. So, the defense industry has pretty much narrow- and wide-moat companies in general, and the biggest contributor is what we call intangibles, really the know-how to produce large projects over a lot of different supply bases across the entire U.S. For example, the F-35 has constituents in 48 states. So, the ability for Lockheed Martin, the company that sort of procures the F-35, to be able to go and manage the entire supply chain is a pretty immense task. And that's one of the big reasons why almost all the defense companies have some sort of moat rating because they all have intangibles they've learned through over the last 50 to 100 years.

Another one is low costs. A lot of these facilities that the defense companies operate were actually owned by the government, and they were basically transitioned over to the big defense contractors kind of for free, and so it's really difficult to replicate that sort of cost.

And finally the big one is switching costs. So, once you have a platform in play, everybody in the armed forces has to be retrained for you to move to a new platform, which is a really immense cost. I mean, think about old people, new people, everybody coming to the channel and having to be retrained on a particular platform, say, the F-16. I mean, it's been around for 35 years now. When we transition over to the F-35, it's going to be a really big cost, so the Pentagon, the Defense Department, and the Air Force have been talking a long time to move this transition.

Coffina: So, earlier in the year it seemed like every day we were hearing about sequestration. More recently, I haven't heard anything about this. So, where are we with the sequestration? Are the cuts in the defense budget going through, and what can be done about at this point?

Dihora: Yeah, so the sequestration actually became law on March 1, 2013, so it's in play, it's actually happening. Some of the early commentary or some of the early moves that the Defense Department and other federal agencies made was furloughs. So, we've kind of heard that through some channels; I mean some of the newspapers talk about it, some of them don't. When we talk to the defense companies, they have not gotten any commentary on large project cancelations. Where they have seen it is sort of what they call short-cycle programs, or programs that start and begin in a short frame of time, so, something like an information technology project. I want to install four computers; well it's done, I'm done with it, I don't need a new project. And most of the new projects have not been starting in IT, meaning, ones that we can control.

Something we can't control are submarines. And once you start one, you can't really stop, otherwise it's not going to float anywhere or even go underwater.

So, those large projects really have been well-funded for multiple years, and those aren't going to be impacted by the sequester. But it is the law. In 2013, it's about $44 billion, and next year it's going to be about $55 billion. And it runs for about nine years. So, we've got to find this money from somewhere, unless something changes within Congress and the executive departments.

Coffina: So, following most of the wars of the 20th century, the Korean War, World War II, the Vietnam War, it took about three to four years for defense spending to start growing again after those conflicts. The Cold War was an exception. During the military buildup of the 1980s, it took almost a decade for us to get back to the spending levels that we reached in the late '80s. Now that Afghanistan is winding down, the Iraq war is over, what kind of situation do you think we're in? How long do you think it will take for defense spending to start growing again?

Dihora: That's a great question, and it depends on your baseline. So, if you say that the Defense Department's budget is what we call the base budget, which has been around $530 billion since fiscal year 2010, we'll probably start growing that post the $55 billion sequestration implementation in 2014. So in 2015 we'll start growing again. If you include overseas contingency operations, which is war funding, that's going to be a little tougher. We peaked out $691 billion. I'm not sure we get there for at least until 2019, 2020 kind of years. That's at least our current framework or frame of thought.

What's happened is that a lot of that spending was probably overspending by the government. Meaning, "We need it today. We'll spend 4 times what it really takes to get there." So, some of those companies or some of those costs were really never supposed to be at that level anyway. But in general, I think the two to three years is actually a pretty good estimate in terms of getting back to growth, and then if you include the war funding, it's probably more like six- or seven-year time frame.

Coffina: So, General Dynamics, which we own in StockInvestor's real money, Tortoise Portfolio, had been your top pick. The stock's been up quite a bit in the last few months. Is that still your favorite name, or do you have any other ideas in defense?

Dihora: Yeah, I think within the defense sector, General Dynamics remains my top pick because they have the most opportunity to gain from their own changes to their businesses. So, a lot of the other guys already made a lot of cost cuts, they've reduced employee counts, they've done the capital-allocation changes, whereas General Dynamics really hasn't done any of that. And I think one of the reasons, if you look back to 2012, they had a CEO transition on plan, under plan and executed well. But that didn't allow the old CEO to really make the changes that he might have thought were necessary because that would sort of play on the new CEO's visions. I mean, nobody really knows how the new CEO sort of wanted to implement all the different things that she wanted to do, whereas [former CEO] Jay Johnson kind of had his own thoughts.

So, my opinion is GD still has a lot of work to do. I mean, they've really not cut employee levels since 2008, and other companies have done kind of 7% to 15% cuts. They have not really done a whole lot of capital-allocation strategies. I mean they pay a good dividend yield, like 3.3%. I'm not sure of the current price; maybe it's different. But they haven't really done a whole lot of share repurchases. We have a competitor, Northrop Grumman, who wants to buy back 25% of their company in stock. And so, I think General Dynamics even from here still represents one of the best opportunities because they have almost all three levers at play. I mean, they can do internal execution changes, they can do capital allocation strategies, and they can really figure out which of their businesses are going to do much better after implementing these strategies.

It might be never, but investors should focus on how share price relates to a company's intrinsic value and also consider their alternatives before making a move, says StockInvestor editor Matt Coffina.

It might be never, but investors should focus on how share price relates to a company's intrinsic value and also consider their alternatives before making a move, says StockInvestor editor Matt Coffina.